In a week where Jerome Powell, the Fed’s Chair, is about to have three public statements, the USD appears to be back in fashion as investors look for safety in the world’s reserve currency.
The stock market selloff in recent days suggests the liquidity constraints remain and the US Treasury actions are as important as the Fed’s ones.
US Treasury Building a Cash Buffer
To the surprise of many market participants, the US Treasury issued more debt than the Fed issued new money. While the asset purchasing by the Fed started again in response to the coronavirus crisis, so did the US Treasury issuing.
The stock market recovery after the drop in March this year was mainly attributed to the Fed’s opening of USD swap lines. Once the USD liquidity increased, the markets calmed, and a smooth recovery started.
However, at the same time, the US Treasury issued debt at a faster pace. It even built a cash buffer lately. The mathematics of this process (i.e. higher debt issuance than Fed’s asset purchasing) leads to a net shrinking of USD liquidity. This is one of the reasons why the stock market sold last week and looks fragile today (US futures point to another weak start).
The big question now is what the Fed would do for the second half of the year? If the Treasury keeps outpacing the Fed, the shrinking USD liquidity will likely put more pressure on the stock market. Therefore, the Fed will likely try to outpace US Treasury issuing, in order to increase the USD available. This, in turn, should create further pressure in the spot markets on the USD pairs and put a floor below the falling US stock market.
For market participants, the DXY (Dollar Index) is the bellwether or the benchmark to compare against. As it turns out, the USD liquidity conditions lead the DXY changes by up to two months. In other words, summer trading (i.e., June-July-August) should see lower DXY judging by the Fed’s actions in April and May, while reversing afterward judging by what the US Treasury did.
As always, the mathematics of it is not that simple. That should happen, assuming both the Fed and the US Treasury will not change anything in the meantime – which is unlikely, considering the severity of the current economic recessions.
Therefore, the likelihood is that both the Fed, the US Treasury will remain active players in the international financial markets, fighting to steam the impact of the coronavirus recession.